Friday, October 16, 2015

Should I buy Wal-Mart stock at current levels?

On Wednesday, Wal-Mart (WMT) stock fell by 10% in a single day due to lowering its future estimates. This is a large drop from a company with a market capitalization of roughly 200 billion dollars and almost half a trillion in annual sales.

As an investor, I can do two things – I can either buy more or not do anything.

The case for buying more Wal-Mart stock is the fact that the shares are selling at a P/E of 13.10 and an yield of 3.30%. This is certainly the lowest valuation I have seen for Wal-Mart in quite some time. In addition, the company has recently approved a $20 billion dollar share buyback, which at current prices could retire approximately 10% of shares outstanding. While the company is expecting a hit to earnings through FY 2017 ( which is calendar year 2016), it then expects a rebound in earnings per share and slight growth. Furthermore, the company expects 3% - 4% annual growth in revenues over the next three - four years.

On the other hand, there is also the case against buying Wal-Mart for a passive buy and hold dividend portfolio. The first reason is that there has been no growth in earnings per share for the past three years. It looks like there will be no growth in earnings per share in 2015 and 2016 ( equivalent to fiscal years 2016 and 2017). Growth in dividends per share has been anemic for two years in a row as well. As a result, the intrinsic value of the business is not increasing either. This means that the compounding machine is not compounding – it is just treading water.

Despite the cheap valuation, I am leaning towards not adding to Wal-Mart. I want to buy a stake in a quality business at a decent price. However I also want to see growth in earnings and dividends, in order to be compensated for inflation. At a current yield of 3.30% and expected dividend growth of 3%, I do not believe I am well compensated for taking on more risk with Wal-Mart.

I realize however that I could be wrong in my decision. It is possible that the stock price could increase to say $80/share within a year, mostly due to changes in valuation, caused by changes in investor expectations. But then I would have to time my exit perfectly if the business hasn’t really returned to a steady rate of growth when this happens. This is time consuming, as I would have to sell at the right price and then find another company to compound my capital with. Otherwise, the valuation could quickly go down again or stay flat.

I don’t know about you, but I am not good with market timing. Most investors are bad with market timing too. As a result, I have found that time in the market trumps timing the market – but only if you have selected the right company that will grow earnings, dividends and intrinsic value for you over time. I do not want to micromanage my investments, but rather find the companies that will do the heavy lifting for me.

I could also turn out to be wrong about the long-term prospects of Wal-Mart. If the company returns to a conservative 5% - 6% annual growth in earnings per share, coupled with a 3% dividend yield, long-term investors could do pretty well over time. This is precisely the reason why I am holding on to my Wal-Mart stock.

As a long term investor I bet on improvement in the ability of the business to grow earnings per share, dividends per share and intrinsic value. I do not rely on valuation expansions nor do I rely on market timing. If you believe that things are temporarily weak, and the business will rebound over time, then it makes sense to add. However, it is a nice reminder that growth could be tougher for a company with $500 billion in annual sales

Either way, I will keep on to my existing holdings in Wal-Mart. I will reinvest dividends in tax-deferred accounts automatically (drip), but allocate cash dividends from taxable accounts elsewhere.

If I feel like speculating, I would sell a March or June 2016 put at or below a strike price of $57.50. The premium is $3.40 for the March contract and $4.20 for the June contract. If the company raises its quarterly dividend to 50 cents/share in early 2016, I would feel better earning a 3.70% - 3.75% yield from the get go assuming that the option is exercised.

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